PANW-04.30.2015-10Q (Q315)
Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________ 
Form 10-Q
 _____________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended April 30, 2015
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to             
Commission File Number 001-35594
Palo Alto Networks, Inc.
(Exact name of registrant as specified in its charter)
 
 
Delaware
20-2530195
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
4401 Great America Parkway
Santa Clara, California 95054
(Address of principal executive office, including zip code)
(408) 753-4000
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
x
Accelerated filer
¨
Non-accelerated filer
¨ (Do not check if a smaller reporting company)
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨   No   x
The number of shares outstanding of the registrant's common stock as of May 18, 2015 was 83,659,846.
 


Table of Contents

TABLE OF CONTENTS

 
 
 
 
 
Page
 
PART I - FINANCIAL INFORMATION
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
PART II - OTHER INFORMATION
 
Item 1.
Item 1A.
Item 6.

- 2 -
Table of Contents

PART I

ITEM 1.
FINANCIAL STATEMENTS
 
PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share data)
 
April 30, 2015
 
July 31, 2014
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
454,123

 
$
653,812

Short-term investments
368,850

 
118,690

Accounts receivable, net of allowance for doubtful accounts of $855 and $471 at April 30, 2015 and July 31, 2014, respectively
150,523

 
135,518

Prepaid expenses and other current assets
67,013

 
50,306

Total current assets
1,040,509

 
958,326

Property and equipment, net
59,546

 
48,744

Long-term investments
408,465

 
201,880

Goodwill
155,402

 
155,033

Intangible assets, net
43,885

 
47,955

Other assets
76,625

 
66,528

Total assets
$
1,784,432

 
$
1,478,466

Liabilities, temporary equity, and stockholders’ equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
14,661

 
$
14,526

Accrued compensation
53,467

 
48,727

Accrued and other liabilities
28,535

 
25,000

Deferred revenue
365,384

 
259,918

Convertible senior notes, net
481,960

 
—

Total current liabilities
944,007

 
348,171

Convertible senior notes, net
—

 
466,875

Long-term deferred revenue
238,506

 
162,660

Other long-term liabilities
54,601

 
32,177

Commitments and contingencies (Note 7)


 


Temporary equity
93,040

 
—

Stockholders’ equity:
 
 
 
Preferred stock; $0.0001 par value; 100,000 shares authorized; none issued and outstanding at April 30, 2015 and July 31, 2014
—

 
—

Common stock; $0.0001 par value; 1,000,000 shares authorized; 83,599 and 79,519 shares issued and outstanding at April 30, 2015 and July 31, 2014, respectively
8

 
8

Additional paid-in capital
908,867

 
804,406

Accumulated other comprehensive income (loss)
140

 
(105
)
Accumulated deficit
(454,737
)
 
(335,726
)
Total stockholders’ equity
454,278

 
468,583

Total liabilities, temporary equity, and stockholders’ equity
$
1,784,432

 
$
1,478,466

 
See notes to condensed consolidated financial statements.

- 3 -
Table of Contents

PALO ALTO NETWORKS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share data)
 
 
Three Months Ended
 
Nine Months Ended
 
April 30,
 
April 30,
 
2015
 
2014
 
2015
 
2014
Revenue:
 
 
 
 
 
 
 
Product
$
121,524

 
$
84,128

 
$
338,621

 
$
240,436

Services
112,648

 
66,572

 
305,552

 
179,512

Total revenue
234,172

 
150,700

 
644,173

 
419,948

Cost of revenue:
 
 
 
 
 
 
 
Product
32,851

 
20,425

 
92,632

 
58,600

Services
31,544

 
19,285

 
84,549

 
52,421

Total cost of revenue
64,395

 
39,710

 
177,181

 
111,021

Total gross profit
169,777

 
110,990

 
466,992

 
308,927

Operating expenses:
 
 
 
 
 
 
 
Research and development
48,486

 
27,837

 
132,739

 
71,983

Sales and marketing
131,026

 
83,995

 
360,267

 
228,095

General and administrative
26,989

 
23,717

 
72,989

 
57,575

Legal settlement
—

 
121,173

 
—

 
141,173

Total operating expenses
206,501

 
256,722

 
565,995

 
498,826

Operating loss
(36,724
)
 
(145,732
)
 
(99,003
)
 
(189,899
)
Interest expense
(5,631
)
 
(13
)
 
(16,659
)
 
(35
)
Other income (expense), net
(55
)
 
430

 
630

 
665

Loss before income taxes
(42,410
)
 
(145,315
)
 
(115,032
)
 
(189,269
)
Provision for income taxes
3,525

 
1,272

 
3,979

 
5,125

Net loss
$
(45,935
)
 
$
(146,587
)
 
$
(119,011
)
 
$
(194,394
)
Net loss per share, basic and diluted
$
(0.56
)
 
$
(1.96
)
 
$
(1.47
)
 
$
(2.66
)
Weighted-average shares used to compute net loss per share, basic and diluted
82,320

 
74,967

 
80,828

 
73,127


See notes to condensed consolidated financial statements.


- 4 -
Table of Contents

PALO ALTO NETWORKS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited, in thousands)

 
Three Months Ended
 
Nine Months Ended
 
April 30,
 
April 30,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(45,935
)
 
$
(146,587
)
 
$
(119,011
)
 
$
(194,394
)
Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Change in unrealized gains (losses) on investments
(77
)
 
18

 
249

 
87

Reclassification adjustment for realized net gains on investments included in net loss
(4
)
 
—

 
(4
)
 
(10
)
Net change
(81
)
 
18

 
245

 
77

Comprehensive loss
$
(46,016
)
 
$
(146,569
)
 
$
(118,766
)
 
$
(194,317
)

See notes to condensed consolidated financial statements.

- 5 -
Table of Contents

PALO ALTO NETWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
 
Nine Months Ended
 
April 30,
 
2015
 
2014
Cash flows from operating activities
 
 
 
Net loss
$
(119,011
)
 
$
(194,394
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Share-based compensation for equity based awards
155,498

 
66,685

Depreciation and amortization
20,273

 
11,638

Amortization of investment premiums, net of accretion of purchase discounts
2,308

 
1,180

Amortization of debt discount and debt issuance costs
16,610

 
—

Excess tax benefit from share-based compensation arrangements
(518
)
 
(758
)
Changes in operating assets and liabilities, net of effects of acquisitions:
 
 
 
Accounts receivable, net
(15,005
)
 
(27,220
)
Prepaid expenses and other assets
(30,885
)
 
(7,926
)
Accounts payable
(3,896
)
 
8,965

Accrued compensation
4,750

 
6,792

Accrued and other liabilities
27,543

 
131,043

Deferred revenue
181,312

 
118,551

Net cash provided by operating activities
238,979

 
114,556

Cash flows from investing activities
 
 
 
Purchases of investments
(666,471
)
 
(316,911
)
Proceeds from sales of investments
7,000

 
6,630

Proceeds from maturities of investments
200,798

 
198,080

Business acquisitions, net of cash acquired
—

 
(85,726
)
Purchases of property, equipment, and other assets
(21,862
)
 
(31,379
)
Net cash used in investing activities
(480,535
)
 
(229,306
)
Cash flows from financing activities
 
 
 
Proceeds from exercises of stock options
23,136

 
25,431

Proceeds from employee stock purchase plan
18,213

 
12,869

Excess tax benefit from share-based compensation arrangements
518

 
758

Repurchases of restricted common stock from terminated employees
—

 
(132
)
Net cash provided by financing activities
41,867

 
38,926

Net decrease in cash and cash equivalents
(199,689
)
 
(75,824
)
Cash and cash equivalents—beginning of period
653,812

 
310,614

Cash and cash equivalents—end of period
$
454,123

 
$
234,790


See notes to condensed consolidated financial statements.

- 6 -
Table of Contents

 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(All dollar and share amounts rounded to the nearest thousand, except per share data)
1. Description of Business and Summary of Significant Accounting Policies
Description of Business
Palo Alto Networks, Inc. (the “Company,” “we,” “us,” or “our”), located in Santa Clara, California, was incorporated in March 2005 under the laws of the State of Delaware and commenced operations in April 2005. We offer a next-generation enterprise security platform that allows enterprises, service providers, and government entities to simultaneously empower and secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches stemming from targeted cyber attacks.
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, consistent in all material respects with those applied in our Annual Report on Form 10-K for the fiscal year ended July 31, 2014. The condensed consolidated financial statements include all adjustments necessary for a fair presentation of our quarterly results. All adjustments are of a normal recurring nature. We have made estimates and judgments affecting the amounts reported in our condensed consolidated financial statements and the accompanying notes. The actual results that we experience may differ materially from our estimates. Certain prior period amounts have been reclassified to conform with current period presentation.
Principles of Consolidation
The condensed consolidated financial statements include our accounts and our wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Summary of Significant Accounting Policies
There have been no material changes to our significant accounting policies as of and for the nine months ended April 30, 2015, as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended July 31, 2014.
Recent Accounting Pronouncements
In April 2015, the Financial Accounting Standards Board (FASB) issued new authoritative guidance on fees paid in a cloud computing arrangement. The standard requires customers in a cloud computing arrangement to evaluate whether the arrangement includes a software license. If the arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for the arrangement as a service contract. The standard is effective for us for our first quarter of fiscal 2017, although early adoption is permitted, and will be applied on either a prospective or retrospective basis. We are currently evaluating adoption methods and whether this standard will have a material impact on our condensed consolidated financial statements.
In April 2015, the FASB issued updated authoritative guidance to simplify the presentation of debt issuance costs. The amended standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability, consistent with the presentation of debt discounts, instead of being presented as an asset. The amended standard is effective for us for our first quarter of fiscal 2017, although early adoption is permitted, and will be applied on a retrospective basis. Upon adoption, the amended standard will change the classification of our unamortized debt issuance costs in our condensed consolidated balance sheets.
In August 2014, the FASB issued new authoritative guidance about management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The standard is effective for us for our fourth quarter of fiscal 2017, although early adoption is permitted. The adoption of this standard is not expected to have a material impact on our condensed consolidated financial statements.
In May 2014, the FASB issued new authoritative guidance on revenue from contracts with customers. The new standard provides principles for recognizing revenue for the transfer of promised goods or services to customers with the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard also requires significantly expanded disclosures about revenue recognition. The guidance is effective for us for our first quarter of fiscal 2018 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within the guidance; or (ii) retrospective with the cumulative effect of initially applying the guidance recognized at the date of initial application

- 7 -
Table of Contents

and providing certain additional disclosures as defined per the guidance. Early adoption is not permitted. We are currently evaluating adoption methods and whether this standard will have a material impact on our condensed consolidated financial statements.
In July 2013, the FASB issued new authoritative guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The standard requires us to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss (NOL) carryforward or other tax credit carryforward when settlement in this manner is available under applicable tax law. The guidance was effective for us in the first quarter of fiscal 2015. Our adoption of this guidance did not have an impact on our condensed consolidated financial statements.
2. Fair Value Measurements
We categorize assets and liabilities recorded at fair value on our condensed consolidated balance sheets based upon the level of judgment associated with inputs used to measure their fair value. The categories are as follows:
•
Level 1—Inputs are unadjusted quoted prices in active markets for identical assets or liabilities.
•
Level 2—Inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the assets or liabilities, either directly or indirectly through market corroboration, for substantially the full term of the financial instruments.
•
Level 3—Inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. The inputs require significant management judgment or estimation.
The following table presents the fair value of our financial assets and liabilities using the above input categories as of April 30, 2015 and July 31, 2014 (in thousands):
 
 
April 30, 2015
 
July 31, 2014
 
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
Short-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
$
—

 
$
1,000

 
$
—

 
$
1,000

 
$
—

 
$
—

 
$
—

 
$
—

Corporate debt securities
 
—

 
72,072

 
—

 
72,072

 
—

 
22,239

 
—

 
22,239

U.S. government and agency securities
 
—

 
295,778

 
—

 
295,778

 
—

 
96,451

 
—

 
96,451

Total short-term investments
 
—

 
368,850

 
—

 
368,850

 
—

 
118,690

 
—

 
118,690

Long-term investments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
—

 
—

 
—

 
—

 
—

 
1,000

 
—

 
1,000

Corporate debt securities
 
—

 
88,938

 
—

 
88,938

 
—

 
39,018

 
—

 
39,018

U.S. government and agency securities
 
—

 
319,527

 
—

 
319,527

 
—

 
161,862

 
—

 
161,862

Total long-term investments
 
—

 
408,465

 
—

 
408,465

 
—

 
201,880

 
—

 
201,880

Other assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit
 
—

 
—

 
—

 
—

 
1,220

 
—

 
—

 
1,220

Total other assets
 
—

 
—

 
—

 
—

 
1,220

 
—

 
—

 
1,220

Total assets measured at fair value
 
$
—

 
$
777,315

 
$
—

 
$
777,315

 
$
1,220

 
$
320,570

 
$
—

 
$
321,790

Refer to Note 6. Convertible Senior Notes for the carrying amount and estimated fair value of our convertible senior notes as of April 30, 2015.

- 8 -
Table of Contents

3. Investments
The following tables summarize the unrealized gains and losses and fair value of our investments as of April 30, 2015 and July 31, 2014 (in thousands):
 
April 30, 2015
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
1,000

 
$
—

 
$
—

 
$
1,000

Corporate debt securities
161,005

 
53

 
(48
)
 
161,010

U.S. government and agency securities
615,087

 
322

 
(104
)
 
615,305

Total
$
777,092

 
$
375

 
$
(152
)
 
$
777,315

 
July 31, 2014
 
Amortized Cost 
 
Unrealized Gains
 
Unrealized Losses
 
Estimated Fair Value
Certificates of deposit
$
1,000

 
$
—

 
$
—

 
$
1,000

Corporate debt securities
61,299

 
16

 
(58
)
 
61,257

U.S. government and agency securities
258,376

 
45

 
(108
)
 
258,313

Total
$
320,675

 
$
61

 
$
(166
)
 
$
320,570

The following tables present our investments that were in an unrealized loss position as of April 30, 2015 and July 31, 2014 (in thousands):
 
April 30, 2015
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Corporate debt securities
$
77,534

 
$
(48
)
 
$
—

 
$
—

 
$
77,534

 
$
(48
)
U.S. government and agency securities
181,639

 
(104
)
 
—

 
—

 
181,639

 
(104
)
Total
$
259,173

 
$
(152
)
 
$
—

 
$
—

 
$
259,173

 
$
(152
)
 
July 31, 2014
 
Less Than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
 
Fair Value
 
Unrealized Loss
Corporate debt securities
$
43,868

 
$
(58
)
 
$
—

 
$
—

 
$
43,868

 
$
(58
)
U.S. government and agency securities
142,490

 
(108
)
 
—

 
—

 
142,490

 
(108
)
Total
$
186,358

 
$
(166
)
 
$
—

 
$
—

 
$
186,358

 
$
(166
)
Unrealized losses related to these investments are due to interest rate fluctuations as opposed to credit quality. In addition, we do not intend to sell and it is not likely that we would be required to sell these investments before recovery of their amortized cost basis, which may be at maturity. As a result, there is no other-than-temporary impairment for these investments at April 30, 2015.
The following table summarizes the amortized cost and fair value of our investments as of April 30, 2015, by contractual years-to-maturity (in thousands):
 
Amortized Cost
 
Fair Value
Due within one year
$
368,766

 
$
368,850

Due between one and three years
408,326

 
408,465

Total
$
777,092

 
$
777,315


- 9 -
Table of Contents

4. Intangible Assets
The following table presents details of our purchased intangible assets as of April 30, 2015 and July 31, 2014 (in thousands):
 
 
April 30, 2015
 
July 31, 2014
 
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Intangible assets with finite lives:
 
 
 
 
 
 
 
 
 
 
 
 
Developed technology
 
$
42,100

 
$
(5,974
)
 
$
36,126

 
$
34,500

 
$
(1,643
)
 
$
32,857

Acquired intellectual property
 
8,156

 
(1,645
)
 
6,511

 
6,546

 
(958
)
 
5,588

In-process research and development held for defensive purposes
 
1,900

 
(844
)
 
1,056

 
1,900

 
(370
)
 
1,530

Other
 
500

 
(308
)
 
192

 
500

 
(120
)
 
380

Total intangible assets with finite lives
 
52,656

 
(8,771
)
 
43,885

 
43,446

 
(3,091
)
 
40,355

In-process research and development with indefinite lives
 
—

 
—

 
—

 
7,600

 
—

 
7,600

Total purchased intangible assets
 
$
52,656

 
$
(8,771
)
 
$
43,885

 
$
51,046

 
$
(3,091
)
 
$
47,955

We recognized amortization expense of $1,971,000 and $5,680,000 for the three and nine months ended April 30, 2015, respectively, and $820,000 and $1,245,000 for the three and nine months ended April 30, 2014, respectively. Our in-process research and development acquired from Cyvera Ltd. (“Cyvera”) in April 2014 was transferred to developed technology during the three months ended October 31, 2014 and is being amortized over its estimated useful life of seven years.
The following table summarizes our estimated future amortization expense of intangible assets with finite lives by type as of April 30, 2015 (in thousands):
 
Fiscal Years Ending July 31,
 
Remaining 2015
 
2016
 
2017
 
2018
 
2019
 
2020 and Thereafter
Developed technology
$
1,502

 
$
6,014

 
$
6,014

 
$
6,014

 
$
6,014

 
$
10,568

Acquired intellectual property
245

 
947

 
853

 
617

 
511

 
3,338

In-process research and development held for defensive purposes
159

 
633

 
264

 
—

 
—

 
—

Other
62

 
130

 
—

 
—

 
—

 
—

Total future amortization expense
$
1,968

 
$
7,724

 
$
7,131

 
$
6,631

 
$
6,525

 
$
13,906

5. Other Financial Information
The following table presents details of our other assets as of April 30, 2015 and July 31, 2014 (in thousands):
 
April 30, 2015
 
July 31, 2014
Intellectual property licenses
$
41,310

 
$
46,997

Deferred tax charge
29,009

 
—

Debt issuance costs
—

 
12,332

Other assets
6,306

 
7,199

Total other assets
$
76,625

 
$
66,528

In December 2014, we reorganized our corporate structure to more closely align with the global nature of our business. As a result, we recorded a deferred tax charge in other assets in our condensed consolidated balance sheets. This amount is being amortized on a straight-line basis over approximately six years as a component of provision for income taxes in our condensed consolidated statements of operations.

- 10 -
Table of Contents

6. Convertible Senior Notes
Convertible Senior Notes
On June 30, 2014, we issued $575,000,000 aggregate principal amount of 0.0% Convertible Senior Notes due 2019 (the “Notes”). The Notes are governed by an indenture between us, as the issuer, and U.S. Bank National Association, as Trustee (the “Indenture”). The Notes are unsecured, unsubordinated obligations that do not contain any financial covenants or restrictions on the payments of dividends, the incurrence of indebtedness, or the issuance or repurchase of securities by us or any of our subsidiaries. The Notes mature on July 1, 2019 unless converted or repurchased in accordance with their terms prior to such date. We cannot redeem the Notes prior to maturity.
The Notes are convertible for up to 5,214,000 shares of our common stock at an initial conversion rate of approximately 9.068 shares of common stock per $1,000 principal amount, which is equal to an initial conversion price of approximately $110.28 per share of common stock, subject to adjustment. Holders of the Notes may surrender their Notes for conversion at their option at any time prior to the close of business on the business day immediately preceding January 1, 2019, only under the following circumstances:
•
during any fiscal quarter commencing after the fiscal quarter ending on October 31, 2014 (and only during such fiscal quarter), if the last reported sale price of our common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is greater than or equal to 130% of the conversion price for the Notes on each applicable trading day;
•
during the five business day period after any five consecutive trading day period (the “measurement period”), in which the trading price per $1,000 principal amount of Notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate for the Notes on each such trading day; or
•
upon the occurrence of specified corporate events.
On or after January 1, 2019, holders may convert all or any portion of their Notes at any time prior to the close of business on the second scheduled trading day immediately preceding the maturity date regardless of the foregoing conditions. Upon conversion, holders will receive cash equal to the aggregate principal amount of the Notes to be converted, and, at our election, cash and/or shares of our common stock for any amounts in excess of the aggregate principal amount of the Notes being converted.
The conversion price will be subject to adjustment in some events. Holders of the Notes who convert their Notes in connection with certain corporate events that constitute a “make-whole fundamental change” per the Indenture are, under certain circumstances, entitled to an increase in the conversion rate. Additionally, upon the occurrence of a corporate event that constitutes a “fundamental change” per the Indenture, holders of the Notes may require us to repurchase for cash all or a portion of the Notes at a purchase price equal to 100% of the principal amount of the Notes plus accrued and unpaid contingent interest.
In accounting for the issuance of the Notes, we separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the par value of the Notes as a whole. The difference between the principal amount of the Notes and the liability component (the “debt discount”), is amortized to interest expense using the effective interest method over the term of the Notes. The equity component of the Notes was recorded in additional paid-in capital in our condensed consolidated balance sheets and is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for the transaction costs related to the issuance of the Notes, we allocated the total amount incurred to the liability and equity components using the same proportions as the proceeds from the Notes. Transaction costs attributable to the liability component were recorded in other assets in our condensed consolidated balance sheets and are being amortized to interest expense in our condensed consolidated statements of operations using the effective interest method over the term of the Notes. Transaction costs attributable to the equity component were netted with the equity component of the Notes in additional paid-in capital in our condensed consolidated balance sheets. We recorded liability issuance costs, or debt issuance costs, of $12,497,000 and equity issuance costs of $2,949,000.
During the fiscal quarter ended April 30, 2015, the last reported sale price of our common stock was greater than or equal to 130% of the conversion price of the Notes for at least 20 of the last 30 consecutive trading days of such quarter. As a result, holders may convert their Notes at any time during the fiscal quarter ending July 31, 2015. Accordingly, as of April 30, 2015, we reclassified the net carrying amount of the Notes and related debt issuance costs to current liabilities and current assets, respectively, in our condensed consolidated balance sheets. We also reclassified a portion of the equity component representing the conversion option to temporary equity in our condensed consolidated balance sheets. The amount reclassified to temporary equity was measured as the difference between the principal and net carrying amount of the Notes as of April 30, 2015.

- 11 -
Table of Contents

The following table sets forth the components of the Notes as of April 30, 2015 and July 31, 2014 (in thousands):
 
April 30, 2015
 
July 31, 2014
Liability:
 
 
 
Principal
$
575,000

 
$
575,000

Less: debt discount, net of amortization
93,040

 
108,125

Net carrying amount
$
481,960

 
$
466,875

The total estimated fair value of the Notes was $836,987,000 and $587,087,000 at April 30, 2015 and July 31, 2014, respectively. The fair value was determined based on the closing trading price per $100 of the Notes as of the last day of trading for the period. We consider the fair value of the Notes at April 30, 2015 and July 31, 2014 to be a Level 2 measurement. The fair value of the Notes is primarily affected by the trading price of our common stock and market interest rates. As of April 30, 2015, the if-converted value of the Notes exceeded its principal amount by $188,879,000.
The following table sets forth interest expense recognized related to the Notes for the three and nine months ended April 30, 2015 (dollars in thousands):
 
Three Months Ended
 
Nine Months Ended
 
April 30, 2015
Amortization of debt issuance costs
$
522

 
$
1,524

Amortization of debt discount
5,088

 
15,085

Total interest expense recognized
$
5,610

 
$
16,609

 
 
 
 
Effective interest rate of the liability component
4.8
%
 
4.8
%
Note Hedges
To minimize the impact of potential economic dilution upon conversion of the Notes, we entered into convertible note hedge transactions (the “Note Hedges”) with respect to our common stock concurrent with the issuance of the Notes. The Note Hedges cover up to 5,214,000 shares of our common stock at a strike price per share that corresponds to the initial conversion price of the Notes, which are also subject to adjustment, and are exercisable upon conversion of the Notes. The Note Hedges will expire upon maturity of the Notes. The Note Hedges are separate transactions and are not part of the terms of the Notes. Holders of the Notes will not have any rights with respect to the Note Hedges. The shares receivable related to the Note Hedges are excluded from the calculation of diluted earnings per share as they are antidilutive.
We paid an aggregate amount of $110,975,000 for the Note Hedges, which is included in additional paid-in capital in our condensed consolidated balance sheets.
Warrants
Separately, but concurrently with our issuance of the Notes, we entered into warrant transactions (the “Warrants”) whereby we sold warrants to acquire up to 5,214,000 shares of our common stock at a strike price of approximately $137.85 per share, subject to adjustments. The shares issuable under the Warrants will be included in the calculation of diluted earnings per share when the average market value per share of our common stock for the reporting period exceeds the strike price of the Warrants. The Warrants are separate transactions and are not part of the Notes or Notes Hedges, and are not remeasured through earnings each reporting period. Holders of the Notes and Note Hedges will not have any rights with respect to the Warrants.
We received aggregate proceeds of $78,258,000 from the sale of the Warrants, which is included in additional paid-in capital in our condensed consolidated balance sheets.
7. Commitments and Contingencies
Leases
We lease our facilities under various non-cancelable operating leases, which expire through the year ending July 31, 2023.

- 12 -
Table of Contents

The following table presents details of the aggregate future non-cancelable minimum rental payments under our operating leases as of April 30, 2015 (in thousands):
 
Amount
Fiscal years ending July 31:
 
Remaining 2015
$
4,344

2016
17,818

2017
16,467

2018
13,339

2019
11,056

2020 and thereafter
43,196

Committed gross lease payments
106,220

Less: proceeds from sublease rental
8,939

Net operating lease obligation
$
97,281

Contract Manufacturer Commitments
Our independent contract manufacturer procures components and assembles our products based on our forecasts. These forecasts are based on estimates of demand for our products primarily for the next twelve months, which are in turn based on historical trends and an analysis from our sales and product marketing organizations, adjusted for overall market conditions. In order to reduce manufacturing lead times and plan for adequate supply, we may issue forecasts and orders for components and products that are non-cancelable. Obligations under contracts that we can cancel without a significant penalty are not included. As of April 30, 2015, we had $41,772,000 of open orders.
Litigation
In December 2011, Juniper Networks, Inc. (“Juniper”) filed a complaint against us in the United States District Court for the District of Delaware alleging patent infringement, which sought preliminary and permanent injunctions against infringement, treble damages, and attorneys' fees. On September 30, 2013, we filed a lawsuit against Juniper in the United States District Court for the Northern District of California alleging that Juniper’s products infringe three of our U.S. patents, and sought monetary damages and a permanent injunction. On May 27, 2014, we entered into a Settlement, Release and Cross-License Agreement (the “settlement agreement”) with Juniper to resolve all pending litigation between the parties, including those discussed above. Refer to Note 8. Legal Settlement for more information on the settlement agreement.
In addition to the above matter, we are subject to legal proceedings, claims, and litigation arising in the ordinary course of business, including intellectual property litigation. Such matters are subject to many uncertainties and outcomes are not predictable with assurance. We accrue for contingencies when we believe that a loss is probable and that we can reasonably estimate the amount of any such loss.
To the extent there is a reasonable possibility that a loss exceeding amounts already recognized may be incurred and the amount of such additional loss would be material, we will either disclose the estimated additional loss or state that such an estimate cannot be made. As of April 30, 2015, we have not recorded any significant accruals for loss contingencies associated with such legal proceedings, determined that an unfavorable outcome is probable or reasonably possible, or determined that the amount or range of any possible loss is reasonably estimable.
8. Legal Settlement
Mutual Covenant Not to Sue and Release Agreement
On January 27, 2014, we executed a Mutual Covenant Not to Sue and Release Agreement with Fortinet, Inc., thereby extending an existing covenant for six more years. We evaluated the transaction as a multiple-element arrangement and allocated the one-time payment that we made in the amount of $20,000,000 to each identifiable element using its relative fair value. Based on our estimates of fair value, we determined that the primary benefit of the arrangement is avoided litigation cost and the release of any potential past claims, with no material value attributable to future use or benefit. Accordingly, we recorded a $20,000,000 settlement charge within legal settlement expense in our condensed consolidated statement of operations during the three months ended January 31, 2014.

- 13 -
Table of Contents

Settlement, Release and Cross-License Agreement with Juniper
On May 27, 2014, we entered into the settlement agreement with Juniper, whereby we resolved all pending litigation matters. Under the terms of the settlement agreement, we agreed to pay Juniper a one-time settlement amount comprised of $75,000,000 in cash, 1,081,000 shares of our common stock, and a warrant to purchase 463,000 shares of our common stock, in exchange for the following:
•
Mutual dismissal with prejudice of all pending litigation between the parties and general release of all liability for Palo Alto Networks and Juniper,
•
Cross-license between both parties for the patents-in-suit and associated family members and counterparts worldwide for the life of the patents, and
•
Mutual covenant not to sue for infringement of any other patents for a period of eight years.
The fair value of the total consideration as of the settlement date was $182,473,000, which was comprised of $75,000,000 in cash, $75,231,000 in common stock, and $32,242,000 in warrant. The fair values of the common stock and warrant were measured using the closing price of our common stock on the settlement date.
The warrant was issued on June 3, 2014 and entitled Juniper to purchase up to 463,000 shares of common stock at an exercise price of $0.0001 per share and was classified as a liability during the period it was outstanding. On July 1, 2014, Juniper exercised the warrant in full. Accordingly, we recorded the change in the fair value of the warrant liability through the exercise date of $5,859,000 within other income (expense), net in our consolidated statement of operations during the three months ended July 31, 2014.
We accounted for the settlement agreement as a multiple-element arrangement and allocated the fair value of the consideration as of the settlement date to the identifiable elements based on their estimated fair values. Of the total settlement amount, $61,300,000 was allocated to the licensing of intellectual property, $54,300,000 was allocated to the mutual dismissal of claims, and the remaining amount was allocated to the mutual covenant not to sue. The mutual dismissal of claims and the mutual covenant not to sue have no identifiable future benefit, and as a result we recorded a settlement charge within legal settlement expense in our condensed consolidated statement of operations during the three months ended April 30, 2014. The licensing of intellectual property is being amortized to cost of product revenue in our condensed consolidated statements of operations over the estimated period of benefit of five years.
9. Equity Award Plans
Stock Option Activities
A summary of the activity under our stock plans during the reporting period and a summary of information related to options exercisable, vested, and expected to vest are presented below (in thousands, except per share amounts):
 
Options Outstanding 
 
Number
of
Shares
 
Weighted-
Average
Exercise
Price Per Share 
 
Weighted-
Average
Remaining
Contractual
Term
(Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2014
5,830

 
$
13.02

 
7.0
 
$
395,507

Options granted
—

 
—

 
 
 
 
Options forfeited
(51
)
 
17.57

 
 
 
 
Options exercised
(1,953
)
 
11.85

 
 
 
 
Balance—April 30, 2015
3,826

 
$
13.56

 
6.4
 
$
513,296

Options vested and expected to vest—April 30, 2015
3,792

 
$
13.50

 
6.4
 
$
508,962

Options exercisable—April 30, 2015
2,748

 
$
11.67

 
6.2
 
$
373,865


- 14 -
Table of Contents

Restricted Stock Unit (RSU) Activities
A summary of the activity under our stock plans during the reporting period and a summary of information related to RSUs vested and expected to vest are presented below (in thousands, except per share amounts):
 
RSUs Outstanding
 
Number
of
Shares
 
Weighted-
Average
Grant-Date Fair Value Per Share
 
Weighted-
Average
Remaining
Contractual
Term
(Years)
 
Aggregate
Intrinsic
Value
Balance—July 31, 2014
6,046

 
$
59.84

 
1.4
 
$
488,880

RSUs granted
3,459

 
110.53

 
 
 
 
RSUs vested
(1,885
)
 
56.59

 
 
 
 
RSUs forfeited
(370
)
 
67.64

 
 
 
 
Balance—April 30, 2015
7,250

 
$
84.47

 
1.3
 
$
1,070,970

RSUs vested and expected to vest—April 30, 2015
6,610

 
$
83.99

 
1.3
 
$
976,429

Share-Based Compensation
The following table summarizes share-based compensation included in costs and expenses (in thousands):
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2015
 
2014
 
2015
 
2014
Cost of product revenue
$
1,031

 
$
417

 
$
2,735

 
$
1,001

Cost of services revenue
5,587

 
2,739

 
14,222

 
6,310

Research and development
19,821

 
8,666

 
52,810

 
17,825

Sales and marketing
22,168

 
12,372

 
59,694

 
29,050

General and administrative
11,627

 
3,798

 
26,129

 
12,601

Total
$
60,234

 
$
27,992

 
$
155,590

 
$
66,787

At April 30, 2015, total compensation cost related to unvested share-based awards not yet recognized was $510,411,000, net of estimated forfeitures. This cost is expected to be amortized on a straight-line basis over a weighted-average period of approximately three years.
10. Income Taxes
Our provision for income taxes for the three and nine months ended April 30, 2015 reflects an effective tax rate of negative 8.3% and negative 3.5%, respectively. Our effective tax rate for these periods were negative as we recorded a provision for income taxes on year to date losses. The key components of our income tax provision consist of foreign income, foreign withholding taxes, U.S. federal and state income taxes, and amortization of our deferred tax charge. Key components of our effective tax rate consist of foreign tax losses which derive no benefit, non-deductible share-based compensation, and changes in our valuation allowance. As compared to the same periods last year, our effective tax rate changed due to a shift in geographical mix of income and amortization of our deferred tax charge.
Our provision for income taxes for the three and nine months ended April 30, 2014 reflects an effective tax rate of negative 0.9% and negative 2.7%, respectively. Our effective tax rates for these periods were negative due to the fact that we recorded a provision for income taxes on year to date losses. The key components of our income tax provision, and the related effective tax rate, consist of foreign tax losses which derive no benefit, non-deductible share-based compensation, and foreign withholding taxes.
In December 2014, the Tax Increase Prevention Act of 2014 was signed into law, which retroactively extends the federal research and development credit, bonus depreciation, and other corporate tax incentives through December 31, 2014. The benefit from income tax derived from this for the fiscal year ending July 31, 2015 is dependent on actual results for the year.
As of April 30, 2015, we had $57,573,000 of unrecognized tax benefits, $4,888,000 of which would affect income tax expense if recognized, after consideration of our valuation allowance in the U.S. and other assets. The increase in unrecognized tax benefits since July 31, 2014 relates to positions taken in the current year. As of April 30, 2015, our federal, state, and foreign returns for the tax

- 15 -
Table of Contents

years 2008 through the current period remain open to examination. Fiscal years outside the normal statute of limitation remain open to audit by tax authorities due to tax attributes generated in earlier years, which have been carried forward and may be audited in subsequent years when utilized. We do not expect the unrecognized tax benefits to change significantly over the next 12 months. We recognize both interest and penalties associated with uncertain tax positions as a component of income tax expense. The ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty.
11. Net Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing net income (loss) by basic weighted-average shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by diluted weighted-average shares outstanding, including potentially dilutive securities.
The following table presents the computation of basic and diluted net loss per share of common stock (in thousands, except per share data):
 
Three Months Ended
 
Nine Months Ended
 
April 30,
 
April 30,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(45,935
)
 
$
(146,587
)
 
$
(119,011
)
 
$
(194,394
)
Weighted-average shares used to compute net loss per share, basic and diluted
82,320

 
74,967

 
80,828

 
73,127

Net loss per share, basic and diluted
$
(0.56
)
 
$
(1.96
)
 
$
(1.47
)
 
$
(2.66
)
The following securities were excluded from the computation of diluted net loss per share of common stock for the periods presented as their effect would have been antidilutive (in thousands):
 
April 30,
 
2015
 
2014
Options to purchase common stock
3,826

 
6,596

RSUs
7,250

 
5,310

ESPP shares
28

 
41

Convertible senior notes
5,214

 
—

Warrants related to the issuance of convertible senior notes
5,214

 
—

Total
21,532

 
11,947

12. Subsequent Event
In May 2015, we completed our acquisition of CirroSecure, Inc., a privately-held cybersecurity company, in exchange for total consideration of approximately $18,000,000. The acquisition expands the functionality of our enterprise security platform by providing additional security for SaaS applications. We are currently in the process of finalizing the accounting for this transaction and expect to complete our preliminary allocation of the purchase consideration to the assets acquired and liabilities assumed by the end of fiscal 2015.

- 16 -
Table of Contents

ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things: expectations regarding drivers of and factors affecting growth in our business; statements regarding trends in billings, revenue, cost of revenue, gross margin, cash flows, operating expenses, including future share-based compensation expense, interest expense, income taxes, investments and liquidity; expectations regarding billings and revenue from Traps, our Advanced Endpoint Protection offering; expected recurring revenues resulting from expected growth in our installed base; the sufficiency of our existing cash and investments to meet our cash needs for the foreseeable future; and other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “predicts,” “projects,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, and in particular, the risks discussed under the caption “Risk Factors” in Part II, Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is organized as follows:
•
Overview. A discussion of our business and overall analysis of financial and other highlights in order to provide context for the remainder of MD&A.
•
Key Financial Metrics. An analysis of our generally accepted accounting principles (GAAP) and non-GAAP key financial metrics, which management monitors to evaluate our performance.
•
Financial Overview. A discussion of the nature and trends of components of our financial results.
•
Results of Operations. An analysis of our financial results comparing the three and nine months ended April 30, 2015 to the three and nine months ended April 30, 2014.
•
Liquidity and Capital Resources. An analysis of changes in our balance sheets and cash flows, and discussion of our financial condition and our ability to meet cash needs.
•
Contractual Obligations and Commitments. An overview of our contractual obligations, contingent liabilities, commitments, and off-balance sheet arrangements outstanding as of April 30, 2015, including expected payment schedule.
•
Critical Accounting Policies and Estimates. A discussion of accounting policies that require critical estimates, assumptions, and judgments.
•
Recent Accounting Pronouncements. A discussion of expected impacts of impending accounting changes on financial information to be reported in the future.
•
Available Information. A discussion of sources of additional information available to investors.
Overview
We have pioneered the next-generation of enterprise security with our innovative platform that allows enterprises, service providers, and government entities to simultaneously empower and secure their organizations by safely enabling the increasingly complex and rapidly growing number of applications running on their networks and by preventing breaches stemming from targeted cyber attacks. Our enterprise security platform consists of three major elements: our Next-Generation Firewall, our Advanced Endpoint Protection, and our Threat Intelligence Cloud. Our Next-Generation Firewall delivers application, user, and content visibility and control as well as protection against network-based cyber threats integrated within the firewall through our proprietary hardware and software architecture. Our Advanced Endpoint Protection prevents cyber attacks that aim to exploit software vulnerabilities on a broad variety of fixed and virtual endpoints. Our Threat Intelligence Cloud provides central intelligence capabilities as well as automated delivery of preventative measures against cyber attacks. The cloud-based element of our platform is delivered in the form of a service that can be used either in the public cloud or in a private cloud using a dedicated appliance.     

- 17 -
Table of Contents

We derive revenue from sales of our products and services, which together comprise our platform. Product revenue is generated from sales of our Next-Generation Firewall, which is available in hardware and virtualized form factors. Our Next-Generation Firewall incorporates our proprietary PAN-OS operating system, which provides a consistent set of capabilities across our entire product line. These capabilities include: application visibility and control (App-ID), user identification (User-ID), site-to-site virtual private network (VPN), remote access Secure Sockets Layer (SSL) VPN, and Quality-of-Service (QoS). Our products are designed for different performance requirements throughout an organization, ranging from the PA-200, which is designed for enterprise remote offices, to the PA-7050, which is designed for data centers and high-speed networks. The same firewall functionality that is delivered in our hardware appliances is also available in our VM-Series virtual firewalls, which secure virtualized and cloud-based computing environments. Multiple firewalls can jointly use our WildFire appliance, WF-500, which identifies, analyzes, and blocks known and unknown malware in a private cloud-based environment. Our platform can be centrally managed in both virtualized and hardware appliances across an organization with our Panorama product. In addition, our GlobalProtect appliance, GP-100, provides mobile device management, malware detection, and shares device state information to safely enable mobile devices for business use.
Services revenue is generated from sales of subscriptions and support and maintenance, which together provide us with a source of recurring services revenue. Our Threat Prevention, URL Filtering, GlobalProtect, and WildFire subscriptions provide our end-customers with real-time access to the latest antivirus, intrusion prevention, web filtering, and modern malware prevention capabilities across fixed and mobile devices. Our Advanced Endpoint Protection subscription protects against cyber attacks that exploit software vulnerabilities in Windows-based fixed and virtual endpoints through the use of its unique capability of stopping the underlying exploit techniques, and can prevent cyber attacks without relying on prior knowledge of the attack.
When end-customers purchase an appliance, they typically purchase one or more of our subscriptions for additional functionality, as well as support and maintenance in order to receive ongoing security updates, upgrades, bug fixes, and repairs. We leverage our appliances to sell software as a service (SaaS) subscription services to meet our customers’ evolving enterprise security requirements. Our hybrid SaaS revenue model consists of product, subscriptions, and support and maintenance, which we believe will enable us to benefit from recurring revenues as we continue to grow our installed end-customer base.
We maintain a field sales force that works closely with our channel partners in developing sales opportunities. We use a two-tier, indirect fulfillment model whereby we sell our products and services to our global distributor channel partners, which, in turn, sell our products and services to our reseller network, which then sell to our end-customers. Our channel partners purchase our products and services at a discount to our list prices before reselling them to our end-customers. Our channel partners generally receive an order from an end-customer prior to placing an order with us and generally do not stock appliances.
We continue to invest in innovation and strengthening our product portfolio and in September 2014, announced the availability of Traps, our Advanced Endpoint Protection offering designed to prevent sophisticated cyber attacks on endpoints. We anticipate billings (non-GAAP) from Traps will continue to ramp through the end of fiscal 2015 with a more meaningful revenue contribution in fiscal 2016.
As of April 30, 2015, we had sold to more than 24,000 end-customers in over 140 countries. Our end-customers represent a broad range of industries including education, energy, financial services, government entities, healthcare, Internet and media, manufacturing, public sector, and telecommunications, and include some of the largest Fortune 100 and Global 2000 companies in the world. Also, during the nine months ended April 30, 2015, our headcount increased by 595 to 2,317 employees.
For the third quarter of fiscal 2015 and 2014, revenues were $234.2 million and $150.7 million, respectively, representing year over year growth of 55.4%. All three components of our hybrid SaaS revenue model experienced year over year growth, led by revenue from subscription services, which grew 71.3% to $54.8 million, followed by support and maintenance services, which grew 67.3% to $57.8 million, and product, which grew 44.5% to $121.5 million. Revenue growth reflected rapid adoption of our Next-Generation Firewall and related support and maintenance, as well as increasing momentum in our subscription services business. We believe the growth was also driven by increased security spending by customers, as security continues to be a critical business imperative for every business in the world.
We believe that the growth of our business and our short-term and long-term success are dependent upon many factors, including our ability to extend our technology leadership, grow our base of end-customers, expand deployment of our platform and services within existing end-customers, extend the length of service terms within existing end-customers, and focus on end-customer satisfaction. While these areas present significant opportunities for us, they also pose challenges and risks that we must successfully address in order to sustain the growth of our business and improve our operating results.
To manage any future growth effectively, we must continue to improve and expand our information technology and financial infrastructure, our operating and administrative systems and controls, and our ability to manage headcount, capital, and processes in an efficient manner. Additionally, we face intense competition in our market, and to succeed, we need to innovate and offer products that are differentiated from existing infrastructure products, as well as effectively hire, retain, train, and motivate qualified personnel and senior management. If we are unable to successfully address these challenges, our business, operating results, and prospects could be adversely affected.

- 18 -
Table of Contents

Key Financial Metrics
We monitor the key financial metrics set forth below to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts, and assess operational efficiencies. We discuss revenue, gross margin, and the components of operating loss and margin below under “—Financial Overview” and “—Results of Operations.” The following tables summarize deferred revenue, cash flow provided by operating activities, free cash flow (non-GAAP), and billings (non-GAAP).
 
April 30, 2015
 
July 31, 2014
 
(in thousands)
Total deferred revenue
$
603,890

 
$
422,578

Cash, cash equivalents, and investments
$
1,231,438

 
$
974,382

 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2015
 
2014
 
2015
 
2014
 
(dollars in thousands)
Total revenue
$
234,172

 
$
150,700

 
$
644,173

 
$
419,948

Year over year percentage increase
55.4
 %
 
48.8
 %
 
53.4
 %
 
48.0
 %
Gross margin percentage
72.5
 %
 
73.6
 %
 
72.5
 %
 
73.6
 %
Operating loss
$
(36,724
)
 
$
(145,732
)
 
$
(99,003
)
 
$
(189,899
)
Operating margin percentage
(15.7
)%
 
(96.7
)%
 
(15.4
)%
 
(45.2
)%
Billings (non-GAAP)
$
302,219

 
$
193,890

 
$
825,485

 
$
538,499

Cash flow provided by operating activities
 
 
 
 
$
238,979

 
$
114,556

Free cash flow (non-GAAP)
 
 
 
 
$
217,117

 
$
83,177

•
Deferred Revenue. Our deferred revenue consists of amounts that have been invoiced, but that have not yet been recognized as revenue as of the period end. The majority of our deferred revenue balance consists of subscription and support and maintenance revenue that is recognized ratably over the contractual service period. We monitor our deferred revenue balance because it represents a significant portion of revenue to be recognized in future periods.
•
Cash Flow Provided by Operating Activities. We monitor cash flow provided by operating activities as a measure of our overall business performance. Our cash flow provided by operating activities is driven in large part by sales of our products and from up-front payments for both subscriptions and support and maintenance services. Monitoring cash flow provided by operating activities enables us to analyze our financial performance without the non-cash effects of certain items such as depreciation, amortization, and share-based compensation costs, thereby allowing us to better understand and manage the cash needs of our business.
•
Free Cash Flow (non-GAAP). We define free cash flow, a non-GAAP financial measure, as cash provided by operating activities less purchases of property, equipment, and other assets. We consider free cash flow to be a liquidity measure that provides useful information to management and investors about the amount of cash generated by the business that, after the purchases of property, equipment, and other assets, can be used for strategic opportunities, including investing in our business, making strategic acquisitions, and strengthening the balance sheet. A limitation of the utility of free cash flow as a measure of our financial performance and liquidity is that it does not represent the total increase or decrease in our cash balance for the period. In addition, it is important to note that other companies, including companies in our industry, may not use free cash flow, may calculate free cash flow in a different manner than we do, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of free cash flow as a comparative measure. A reconciliation of free cash flow to cash flow provided by operating activities, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:

- 19 -
Table of Contents

 
Nine Months Ended April 30,
 
2015
 
2014
 
(in thousands)
Free cash flow (non-GAAP):
 
 
 
Cash flow provided by operating activities
$
238,979

 
$
114,556

Less: purchases of property, equipment, and other assets
21,862

 
31,379

Free cash flow (non-GAAP)
$
217,117

 
$
83,177

Net cash used in investing activities
$
(480,535
)
 
$
(229,306
)
Net cash provided by financing activities
$
41,867

 
$
38,926

•
Billings (non-GAAP). We define billings, a non-GAAP financial measure, as total revenue plus the change in deferred revenue, net of acquired deferred revenue, during the period. Billings is a key measure used by our management to manage our business because billings drive deferred revenue, which is an important indicator of the health and visibility of our business. We consider billings to be a useful metric for management and investors, particularly as we experience increased sales of subscriptions and strong renewal rates for subscriptions and support and maintenance services, and monitor our near term cash flows. We believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management. However, it is important to note that other companies, including companies in our industry, may not use billings, may calculate billings differently, may have different billing frequencies, or may use other financial measures to evaluate their performance, all of which could reduce the usefulness of billings as a comparative measure. A reconciliation of billings to revenue, the most directly comparable financial measure calculated and presented in accordance with GAAP, is provided below:
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Billings (non-GAAP):
 
 
 
 
 
 
 
Total revenue
$
234,172

 
$
150,700

 
$
644,173

 
$
419,948

Add: change in total deferred revenue, net of acquired deferred revenue
68,047

 
43,190

 
181,312

 
118,551

Billings (non-GAAP)
$
302,219

 
$
193,890

 
$
825,485

 
$
538,499

Financial Overview
Revenue
We derive revenue from sales of our products and services. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured.
Our total revenue is comprised of the following:
•
Product Revenue. The substantial majority of our product revenue is derived from sales of our appliances. Product revenue also includes revenue derived from software licenses of Panorama, GlobalProtect, and the VM-Series. We recognize product revenue at the time of shipment, provided that all other revenue recognition criteria have been met. As a percentage of total revenue, we expect our product revenue to vary from quarter to quarter based on seasonal and cyclical factors.
•
Services Revenue. Services revenue is derived primarily from Threat Prevention, URL Filtering, WildFire, and GlobalProtect subscriptions and support and maintenance. In addition, in September 2014, we released Traps, our Advanced Endpoint Protection subscription. Our contractual subscription and support and maintenance terms are typically one year, with three to five year terms available. We recognize revenue from subscriptions and support and maintenance over the contractual service period. As a percentage of total revenue, we expect our services revenue to vary from quarter to quarter and increase over the long term as we introduce new subscriptions, renew existing services contracts, and expand our installed end-customer base.

- 20 -
Table of Contents

Cost of Revenue
Our cost of revenue consists of cost of product revenue and cost of services revenue. Our cost of revenue includes costs paid to our third-party contract manufacturer and personnel costs, which consist of salaries, bonuses, and share-based compensation associated with our operations and global customer support organizations. Our cost of revenue also includes allocated costs, which consist of certain facilities, depreciation, benefits, recruiting, and information technology costs that we allocate based on headcount, as well as amortization of intellectual property licenses and intangible assets.
•
Cost of Product Revenue. Cost of product revenue primarily includes costs paid to our third-party contract manufacturer. Our cost of product revenue also includes amortization of intellectual property licenses, product testing costs, allocated costs, warranty costs, shipping costs, and personnel costs associated with logistics and quality control. We expect our cost of product revenue to increase as our product revenue increases.
•
Cost of Services Revenue. Cost of services revenue includes personnel costs for our global customer support organization, amortization of acquired intangible assets, allocated costs, and URL filtering database service fees. We expect our cost of services revenue to increase as our installed end-customer base grows.
Gross Margin
Gross margin, or gross profit as a percentage of revenue, has been and will continue to be affected by a variety of factors, including the average sales price of our products, manufacturing costs, the mix of products sold, and the mix of revenue between products and services. For sales of our products, our higher throughput firewall products generally have higher gross margins than our lower throughput firewall products within each product series. For sales of our services, our subscriptions typically have higher gross margins than our support and maintenance. We expect our gross margins to fluctuate over time depending on the factors described above.
Operating Expenses
Our operating expenses consist of research and development, sales and marketing, general and administrative, and legal settlement expense. Personnel costs are the most significant component of operating expenses and consist of salaries, benefits, bonuses, share-based compensation, and with regard to sales and marketing expense, sales commissions. We expect operating expenses to increase in absolute dollars, and decrease over the long term as a percentage of revenue as we continue to scale our business. As of April 30, 2015, we expect to recognize approximately $510.4 million of share-based compensation expense over a weighted-average period of approximately three years, excluding additional share-based compensation expense related to any future grants of share-based awards. Share-based compensation expense, net of forfeitures, is recognized on a straight-line basis over the requisite service periods of the awards.
•
Research and Development. Research and development expense consists primarily of personnel costs. Research and development expense also includes prototype related expenses and allocated costs. We expect research and development expense to increase in absolute dollars as we continue to invest in our future products and services, although our research and development expense may fluctuate as a percentage of total revenue.
•
Sales and Marketing. Sales and marketing expense consists primarily of personnel costs, including commission costs. We expense commission costs as incurred. Sales and marketing expense also includes costs for market development programs, promotional and other marketing costs, travel costs, professional services, and allocated costs. We continue to increase the size of our sales force and have also substantially grown our sales presence internationally. We expect sales and marketing expense to continue to increase in absolute dollars as we increase the size of our sales and marketing organizations to increase touch points with end-customers and to expand our international presence, although our sales and marketing expense may fluctuate as a percentage of total revenue.
•
General and Administrative. General and administrative expense consists of personnel costs, professional services, and certain non-recurring general expenses. General and administrative personnel include our executive, finance, human resources, legal, and IT organizations. Professional services consist primarily of legal, auditing, accounting, and other consulting costs. We expect general and administrative expense to increase in absolute dollars due to additional costs associated with accounting, compliance, insurance, and investor relations, although our general and administrative expense may fluctuate as a percentage of total revenue.
•
Legal Settlement. Legal settlement expense consists of charges related to the Settlement, Release and Cross-License Agreement (the “Settlement Agreement”) with Juniper Networks, Inc. (“Juniper”) and the Mutual Covenant Not to Sue and Release Agreement with Fortinet, Inc. (“Fortinet”). Refer to the discussion under Note 8. Legal Settlement of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for information related to these matters.


- 21 -
Table of Contents

Interest Expense
Interest expense consists of the amortization of the debt discount and debt issuance costs related to our 0.0% Convertible Senior Notes due 2019 (the “Notes”). This interest expense is non-cash and will range from $22.3 million to $25.7 million per year through fiscal 2019.
Other Income (Expense), Net
Other income (expense), net includes interest income earned on our cash, cash equivalents, and investments, foreign currency re-measurement gains and losses, and foreign currency transaction gains and losses.
Provision for Income Taxes
Provision for income taxes consists primarily of income taxes in foreign jurisdictions in which we conduct business, withholding taxes, federal and state income taxes in the United States, and amortization of our deferred tax charge. We maintain a full valuation allowance for domestic deferred tax assets, including net operating loss carryforwards and tax credits.
During the second quarter of fiscal 2015, we recorded a deferred tax charge of $36.7 million. The current portion of the deferred tax charge is included in prepaid expenses and other current assets and the remainder in other assets in our condensed consolidated balance sheets. The deferred tax charge is being amortized on a straight-line basis over approximately six years as a component of provision for income taxes.
Results of Operations
The following tables summarize our results of operations for the periods presented and as a percentage of our total revenue for those periods. The period to period comparison of results is not necessarily indicative of results for future periods.
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2015
 
2014
 
2015
 
2014
 
(dollars in thousands)
Condensed Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
 
Product
$
121,524

 
$
84,128

 
$
338,621

 
$
240,436

Services
112,648

 
66,572

 
305,552

 
179,512

Total revenue
234,172

 
150,700

 
644,173

 
419,948

Cost of revenue:
 
 
 
 
 
 
 
Product
32,851

 
20,425

 
92,632

 
58,600

Services
31,544

 
19,285

 
84,549

 
52,421

Total cost of revenue
64,395

 
39,710

 
177,181

 
111,021

Total gross profit
169,777

 
110,990

 
466,992

 
308,927

Operating expenses:
 
 
 
 
 
 
 
Research and development
48,486

 
27,837

 
132,739

 
71,983

Sales and marketing
131,026

 
83,995

 
360,267

 
228,095

General and administrative
26,989

 
23,717

 
72,989

 
57,575

Legal settlement
—

 
121,173

 
—

 
141,173

Total operating expenses
206,501

 
256,722

 
565,995

 
498,826

Operating loss
(36,724
)
 
(145,732
)
 
(99,003
)
 
(189,899
)
Interest expense
(5,631
)
 
(13
)
 
(16,659
)
 
(35
)
Other income (expense), net
(55
)
 
430

 
630

 
665

Loss before income taxes
(42,410
)
 
(145,315
)
 
(115,032
)
 
(189,269
)
Provision for income taxes
3,525

 
1,272

 
3,979

 
5,125

Net loss
$
(45,935
)
 
$
(146,587
)
 
$
(119,011
)
 
$
(194,394
)
 
 
 
 
 
 
 
 
Number of employees at period end
 
 

 
2,317

 
1,556



- 22 -
Table of Contents

 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2015
 
2014
 
2015
 
2014
 
(as a percentage of revenue)
Condensed Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
Revenue:
 
 
 
 
 
 
 
Product
51.9
 %
 
55.8
 %
 
52.6
 %
 
57.3
 %
Services
48.1
 %
 
44.2
 %
 
47.4
 %
 
42.7
 %
Total revenue
100.0
 %
 
100.0
 %
 
100.0
 %
 
100.0
 %
Cost of revenue:
 
 
 
 
 
 
 
Product
14.0
 %
 
13.6
 %
 
14.4
 %
 
14.0
 %
Services
13.5
 %
 
12.8
 %
 
13.1
 %
 
12.4
 %
Total cost of revenue
27.5
 %
 
26.4
 %
 
27.5
 %
 
26.4
 %
Total gross profit
72.5
 %
 
73.6
 %
 
72.5
 %
 
73.6
 %
Operating expenses:
 
 
 
 
 
 
 
Research and development
20.7
 %
 
18.5
 %
 
20.6
 %
 
17.1
 %
Sales and marketing
56.0
 %
 
55.7
 %
 
55.9
 %
 
54.3
 %
General and administrative
11.5
 %
 
15.7
 %
 
11.4
 %
 
13.8
 %
Legal settlement
—
 %
 
80.4
 %
 
—
 %
 
33.6
 %
Total operating expenses
88.2
 %
 
170.3
 %
 
87.9
 %
 
118.8
 %
Operating loss
(15.7
)%
 
(96.7
)%
 
(15.4
)%
 
(45.2
)%
Interest expense
(2.4
)%
 
—
 %
 
(2.6
)%
 
—
 %
Other income (expense), net
—
 %
 
0.3
 %
 
0.1
 %
 
0.1
 %
Loss before income taxes
(18.1
)%
 
(96.4
)%
 
(17.9
)%
 
(45.1
)%
Provision for income taxes
1.5
 %
 
0.9
 %
 
0.6
 %
 
1.2
 %
Net loss
(19.6
)%
 
(97.3
)%
 
(18.5
)%
 
(46.3
)%


- 23 -
Table of Contents

Comparison of the Three and Nine Month Periods Ended April 30, 2015 and 2014
Revenue
 
Three Months Ended April 30,
 
 
 
 
 
Nine Months Ended April 30,
 
 
 
 
 
2015
 
2014
 
Change
 
2015
 
2014
 
Change
 
Amount
 
Amount
 
Amount
 
%
 
Amount
 
Amount
 
Amount
 
%
 
(dollars in thousands)
Revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
121,524

 
$
84,128

 
$
37,396

 
44.5
%
 
$
338,621

 
$
240,436

 
$
98,185

 
40.8
%
Services
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Subscription
54,832

 
32,005

 
22,827

 
71.3
%
 
148,606

 
85,619

 
62,987

 
73.6
%
Support and maintenance
57,816

 
34,567

 
23,249

 
67.3
%
 
156,946

 
93,893

 
63,053

 
67.2
%
Total services
112,648

 
66,572

 
46,076

 
69.2
%
 
305,552

 
179,512

 
126,040

 
70.2
%
Total revenue
$
234,172

 
$
150,700

 
$
83,472

 
55.4
%
 
$
644,173

 
$
419,948

 
$
224,225

 
53.4
%
Revenue by geographic theater:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Americas
$
157,725

 
$
98,689

 
$
59,036

 
59.8
%
 
$
436,660

 
$
275,724

 
$
160,936

 
58.4
%
EMEA
45,852

 
32,326

 
13,526

 
41.8
%
 
129,156

 
89,299

 
39,857

 
44.6
%
APAC
30,595

 
19,685

 
10,910

 
55.4
%
 
78,357

 
54,925

 
23,432

 
42.7
%
Total revenue
$
234,172

 
$
150,700

 
$
83,472

 
55.4
%
 
$
644,173

 
$
419,948

 
$
224,225

 
53.4
%
Product revenue increased $37.4 million, or 44.5%, for the three months ended April 30, 2015 compared to the three months ended April 30, 2014. Product revenue increased $98.2 million, or 40.8%, for the nine months ended April 30, 2015 compared to the nine months ended April 30, 2014. The increases in both periods were driven by increased demand, including broader adoption of our PA-7050 firewall. The impact of changes in pricing on our product revenue was insignificant.
Services revenue increased $46.1 million, or 69.2%, for the three months ended April 30, 2015 compared to the three months ended April 30, 2014. Services revenue increased $126.0 million, or 70.2%, for the nine months ended April 30, 2015 compared to the nine months ended April 30, 2014. The increases in both periods were due to increased sales to new and existing end-customers. The relative increases in subscription revenue and support and maintenance revenue will fluctuate over time, depending on the mix of services revenue and the introduction of new subscription offerings. The impact of changes in pricing on our services revenue was insignificant.
With respect to geographic theaters, the Americas contributed the largest portion of the increase in revenue for the three and nine months ended April 30, 2015 compared to the three and nine months ended April 30, 2014 due to its larger and more established sales force compared to our other theaters. Revenue from both EMEA and APAC increased for the three and nine months ended April 30, 2015 compared to the three and nine months ended April 30, 2014 due to our investment in increasing the size of our sales force and number of channel partners in these theaters.

- 24 -
Table of Contents

Cost of Revenue and Gross Margin
 
Three Months Ended April 30,
 
Nine Months Ended April 30,
 
2015
 
2014
 
2015
 
2014
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
Amount
 
Gross Margin
 
(dollars in thousands)
Cost of revenue:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
32,851

 
 
 
$
20,425

 
 
 
$
92,632

 
 
 
$
58,600

 
 
Services
31,544

 
 
 
19,285

 
 
 
84,549

 
 
 
52,421

 
 
Total cost of revenue
$
64,395

 
 
 
$
39,710

 
 
 
$
177,181

 
 
 
$
111,021

 
 
Includes share-based compensation of:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
1,031

 
 
 
$
417

 
 
 
$
2,735

 
 
 
$
1,001

 
 
Services
5,587

 
 
 
2,739

 
 
 
14,222

 
 
 
6,310

 
 
Total share-based compensation included in cost of revenue
$
6,618

 
 
 
$
3,156

 
 
 
$
16,957

 
 
 
$
7,311

 
 
Gross profit:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Product
$
88,673

 
73.0
%